HWMP/BBA/Auditing/Chapter 1: The Nature and Purpose of an

Audit
1.1 The Audit: A Definition
The objective of an audit of financial statements is to enable the auditor to express an opinion whether the
financial statements are prepared, in all material respects, in accordance with an identified financial reporting
framework (IAASB, 2005). An audit would imply (or include) 1) Independence of opinion, 2) Collecting evidence,
3) Forming an opinion 4) Reporting to users

1.2 Why have an audit?

Most large corporate organisations are limited companies which are owned by their shareholders as owners
(principals) and managed by directors (agents) appointed by the shareholders. The directors have day-to-day
control of the business. They prepare annual Financial Statements. Shareholders need to be assured that FS are
accurate. In order to protect themselves, the shareholders must put in place suitable control mechanisms. The
mechanisms of protection are called stewardship or accountability.
Stewardship may be thought of as taking care of the resources of the business and using them to make the
business grow. Accountability is the process whereby the managers of a business report to the owners of a
business on the stewardship they have undertaken.
1.3 Solution to the Agency Problem
It is evident that a mechanism of protection is required to give independent assurance to the shareholders
regarding the credibility of the financial statements. A team of auditors (qualified accountants) from outside the
company will come in to check whether the FS are true and fair - a term meaning that the FS have no material
(important) errors. The criteria that the auditors will use to check the FS are the accounting standards. An audit
report will be written to the shareholders, stating whether, in the auditors' opinion, the FS do, or do not, present a
true and fair view (i.e. positive assurance). On the basis of audited financial statements the shareholders can
take decision. Hence, auditing (to some degree) solves the agency problem.
1.4 Extending the scope of Accountability
In addition to the Shareholders (the equity investor group), the audited (corporate) reports are also used by loan
creditor group (Banks, FIs, etc.), employee group (potential and existing HR), analyst-advisor group, business

contract group (supplier, customer, etc.), the government (for example, taxation authority) and the general public.
(Source: The Corporate Report)
1.5 Audit Expectations and Expectation Gap
There is often a notable difference between the expectations of shareholders and the general public as to the
role of the auditor and the view of the audit profession about the role of the auditor. The difference has been
called an expectations gap.
1.6 Auditing Principles
According to APBs Macfarlane Report (1992) there are 8 principles in Auditing: 1) Integrity, 2) Independence, 3)
Competence, 4) Rigour, 5) Accountability, 6) Judgement, 7) Communication, and 8) Providing value
In 2004 the APB confirmed that from 2005 the standards applicable in the UK would be International Standards
on Auditing, with adaptations for the UK and Ireland.
1.7 Developments of Objectives
Those who analyse the history of auditing practices have identified phases in the development of objectives of
financial auditing. In the late 1980s and the 1990s there was renewed interest from external sources in the
specific obligations of auditors with regard to detection of fraud and error, but the primary objective for the
auditors remained that of attestation.
1.8 Audit Firms and the market for Services
1.8.1 It has been a tradition that professional persons such as accountants should trade as partnerships
1.8.2 From 2000, audit firms have been permitted to incorporate as limited liability partnerships; there are some
arguments both in favour of and against limited incorporation of Audit firms
1.8.3 Services provided by accountancy firms
1.8.4 International accounting networks
1.9 The Issue of Independence
Assurance (or Audit) reports are written for the benefit of the people reading them. The readers need to be able
to trust that the reports are reliable and correct. If they sense any links between the auditors and the things being
audited, they may not trust the opinions given. If there are any links between the auditors and the things being
audited, the report loses credibility and the assurance is undermined. It is therefore a requirement if the auditors
are independent of those they are auditing.
Independence comprises: (a) Independence of mind and (b) Independence in appearance
1.10 Phases of History/Development of Auditing professions
Four phases of development in auditing are identified:

 Formative phase: 19th and early 20th centuries. Emergent phase: mid-20th century.
Contemporary phase: late 20th century. Development phase: late 20th century.
After Enron: Restoring the reputation of audit